Exercises: Investment and sources of finance

Explain the difference between investment and finance, and classify these operations as one or the other: buying a new oven, taking out a bank loan, retaining part of the profits to expand the premises, and leasing a van with a purchase option.

Sources of finance can be internal or external, equity or debt (own or external funds). Classify these four: a share capital increase among partners, self-financing through retained earnings, a five-year bank loan, and machinery leasing.

The figure shows the map of a company's sources of finance. Identify the missing group of sources, marked with "?", state how these sources are also called (equity or debt), and give two examples.

An investment requires an initial outlay of $\$400\,000$ and generates annual cash flows of $\$100\,000$ for six years. a) Calculate its payback period. b) Explain what this criterion measures and what its main limitation is.

A company is choosing between two investments: A costs $\$360\,000$ and returns $\$120\,000$ per year, and B costs $\$480\,000$ and returns $\$160\,000$ per year. a) Calculate the payback period for each. b) Reason why the payback period criterion, used on its own, can lead to a bad decision even if the periods turn out to be equal.

A bakery needs a delivery van and is considering three options: a bank loan to buy it, leasing, or renting. Explain what each option consists of and give an advantage and a disadvantage of each for an SME with limited cash flow.

The partners of a family SME disagree on the allocation of the $\$80,000$ net profit earned this year. The majority partner proposes distributing $100\ \%$ in dividends and financing the opening of a second location (cost: $\$150,000$) entirely with a bank loan at $6\ \%$, arguing that "debt is cheap and profits belong in the owners' pockets." The Chief Financial Officer warns that the current debt-to-equity ratio is already $1.8$ (liabilities over equity) and that the sector faces interest rate hikes. a) Rebut the majority partner's arguments by assessing the impact of their proposal on the company's financial risk and financial autonomy. b) Design a justified alternative proposal that combines self-financing and external funding, detailing the necessary conditions for the investment to create value for the partners.

Two competing companies, ALFA and BETA, have total assets of $\$500,000$ and a projected Earnings Before Interest and Taxes (EBIT) of $\$60,000$. ALFA finances its assets with $80\ \%$ debt at an annual interest rate of $5\ \%$ and $20\ \%$ equity; BETA uses $20\ \%$ debt at $5\ \%$ and $80\ \%$ equity (ignore taxes). a) Calculate the return on equity (ROE) of both companies in the projected scenario and justify in which one financial leverage acts more strongly. b) Predict what will happen to the return on equity and the solvency of each company if a crisis reduces EBIT by $60\ \%$ (down to $\$24,000$). Based on these results, interpret the concept of financial risk.

A management team evaluates a project that requires an initial outlay of $\$10,000$ and will generate two consecutive annual cash flows of $\$6,000$ each. The sales director states: "The project will generate $\$12,000$, so we will make a certain net profit of $\$2,000$ regardless of the economic situation." a) Formally prove the director's flawed reasoning by calculating the Net Present Value (NPV) with a cost of capital of $5\ \%$ and justifying why it is not valid to directly add heterogeneous cash flows over time. b) Determine the discount rate above which the investment would cease to be profitable (calculate its IRR) and interpret what would happen if the central bank raises interest rates above that threshold.